Saturday, March 2, 2013

Dow Theory Special Issue: A new Answer to the New Low Observer (NLO)

The New LowObserver (NLO) is an avid student of the markets. Its website contains a wealth
of information, which spans many subjects (Dow Theory, specific stocks, book
list, market observations, etc.)

NLOposted a comment in my Seeking Alpha blog in the past which
resulted in my post “An Answer to the New Low Observer
(NLO)” which you can find here.

Last February 25, NLO
produced a new comment to a new post of mine in my Seeking Alpha blog. Even
though I tried to address the issues raised by NLO as a simple reply to the
comment, I decided that the breath of topics raised were worth being dealt with
in a separate post. This is what I am doing right now.

Basically,
the allegations put forward by the NLOare
as follows:

·Positions taken in accordance to the “classical/Rhea” Dow Theory last
at least 2-4 years.

·All positions taken in
accordance to the “classical/Rhea” Dow Theory result in profits.

·The positions hitherto suggested in this Dow Theory blog have lasted
substantially less and have resulted in modest profits or minor losses.

·This is likely to be caused by the Dow Theory “flavor” I use (basically
Schannep’s with my own minor departures).

·I should re-appraise my Dow Theory “flavor” as the trends it detects are
not strong enough to result in substantial profits.

I am editing
and simultaneously expanding a chain of comments and replies posted by both the
NLO and truly yours in my Seeking Alpha blog.

Those
interested in getting the full chain of comments are advised to go herebecause this
post is not exhaustive, and some issues were exclusively dealt with by both the
NLO and I in the Seeking Alpha blog.

On the other
hand, some issues are subject to a more comprehensive explanation in this post,
which includes the results of a thorough investigation of all Dow Theory
signals since 1897 to date. Hence, lovers of the Dow Theory should read
both this post, and the comments chain in Seeking Alpha.

I am answering each of the objections raised by the NLO as if I were
answering an email. Thus, I have inserted my answers into the text of the
original NLO’s comment with a different font and red color to make it easy to
distinguish objection and answer.

My clarifications are made in the spirit of deepening our knowledge of the
Dow Theory and are not intended to be contentious or dismissive of diverging
opinions. After all, markets function through the existence of different
opinions. Otherwise, we all would be selling or buying at the same time.

Have a wonderful weekend.

Sincerely,

The Dow Theorist

NLO:

This is getting back to the question of "what has the average length
of the primary trend been historically?"

As we've maintained, primary trends (bullish) historically last at least 2-4
years (as found here: http://seekingalpha.co...).

In all the work on the topic of Dow Theory, I have not seen (showing my lack of
vision on the matter) a primary trend last only a month or two at a time.

Answer:

Let’s focus on the “classical/Rhea” Dow Theory and
let’s look at the whole track record as contained in Schannep’s book (pages
26-29) and his website. Until October 1956, the Dow Theory record reflects the
reconstruction made by Edwards &Magee and from October 1956, until now, the
record was recapitulated by Schannep by applying “classical/Rhea” Dow Theory
rules.

The Dow Theory records spans 116 years, since it
starts in 1897.

Let’s take a look at the results:

The average duration of each transaction taking
according to the classical Dow Theory lasted 712 days. This is slightly less
than 2 years.

All the instances lasting less than 180 days (ca. 6
months) occurred during secular bear markets (save one position, which lasted
only 60 days and was taken in 1990 within the secular 1982-1999 bull market).
Therefore, when assessing the probable duration of a new primary bull market,
it is advisable to try to put the nascent trend in context. If it is born
within a secular bull market, it is likely an “above average” duration. If,
conversely, the market is under the spell of a secular bear market, the odds
favor shorter trends. While I acknowledge than in real time not so easy to
label the market a “secular bullish or bearish”, we can make our guesses.

Thus, we can conclude:

1.The average duration
of the positions taken according to the classical/Rhea Dow Theory last ca. 2
years on average. If we took the mean, we’d derive shorter time spans.

2.While occasionally
we may encounter trends (or better said, positions within a trend) that last 4
years or more, this is by no means the rule but rather the exception.

3.Shorter trends (and
accordingly positions) tend to occur during secular bear markets. In technical parlance,
we would say that the market is prone to false breakouts.

NLO

Additionally, I have
not seen a primary trend where it came out with a negative return in real time
(whether acted upon or not).

Answer:

Neither
have I. By definition, even the smallest trend will show a profit if we measure
from bottom to top. We shouldn’t confuse, though,total
duration of a bull market with total duration of the investments made following
primary bull market signals. This aspect was explained ad nauseam here.

However,
the issue at hand is whether the trend detected by the Dow Theory has
sufficient strength or magnitude to result in profits allowing for the inherent
delay of all timing systems in getting in and out of the trend.

I
guess that what is really meant is that all positions/trades/investments made
according to the “classical/Rhea” Dow Theory resulted in profits.

Well,
let’s look at the record:

9
transactions made according to the Dow Theory resulted in losses for the
investor. 7 such trades took place under secular bear markets. 2 took place
under secular bull markets.

Here
you have the details out of the spreadsheet:

Date Dow IndustrialsPctg lost

SELL

13/05/1940

137.5

-3.56291205

SELL

26/04/1962

678.68

-3.96083037

SELL

25/02/1969

899.8

-4.51226759

SELL

26/01/1970

768.88

-10.6244479

SELL

19/10/1978

846.41

-2.31965009

SELL

03/08/1990

2809.65

-4.27706554

SELL

25/06/2002

9126.8

-4.8054137

SELL

29/09/2008

10365.45

-19.3310017

SELL

04/06/2012

12101.46

-1.56612982

The “classical/Rhea” Dow Theory produced 38
transactions during the 116-yeartime
period. Since 9 trades were losers, 76% of all investments made resulted in
profits. However, 24% of the trades resulted in losses.

Therefore, as it should be expected, there is no
holy grail.
The classical Dow Theory also experiences rough patches. Furthermore, if we
consider that it is more likely than not (valuations, gold/dow ratio, etc.)
that the secular primary bear market is not over yet, then we should conclude
that all investments made according to the primary trend, as detected by the
Dow Theory are facing considerable headwind. Should we fold? No, we have to
take all signals, but being very aware that on a secular basis, we are not
under the most favorable market environment for stocks. If the investor is very
sure of his “secular” assessment, then what I wrote here, with all caveats, may be heeded:

“Of course,
assuming that one is certain and not wrong, the secular condition of the stock
market serves the investor in weighing the amount of capital to be invested in
the stock market. Thus, as an example, if the investor reaches the conclusion
that stocks are in a secular bear market or that valuations are not compelling
whereas gold is in a secular bull market, the investor can allot less capital
to stocks and more to gold.”

NLO:

Furthermore, your
recent work on the "classical" Dow Theory showed exceptional
performance compared to buy-and-hold BUT over periods ranging from a year or
more.

Even though I question any interpretation that shows
only a year for a Dow Theory primary trend, I cannot argue if the beginning and
ending period showed a return that is positive on the representative index.

I feel I was not
clear enough in my posts concerning the assessment of the Dow Theoryperformance.
This is why the subtitle of the first post of this “performance” saga bore the
name “Evaluating
performance on a year-end basis”

In the same vein, I wrote:

I have the Dow Theory versus buy and hold (of the Industrials)
record from 1896 to 2011. So we can
compare on a year-to-year basis (year-end end figures) how buy and hold
fared versus the Dow Theory. Thus, in a given year, buy and hold may have
delivered +10% whereas the Dow Theory merely returned +3% and vice versa.
We take as our reference for a buy and hold investor the Dow Jones Industrials.

Therefore, my studies didn’t imply that the Dow Theory
“trades” or “investments” lasted one year, but merely I took the profit or loss
made on 12/31 by the Dow Theory and buy and hold. If the Dow Theory was fully
invested during 4 years, then I took the unrealized profit or loss accrued at
year-end. If the Dow Theory resulted in a short-lived trade and the investor
was in cash on 12/31, I merely reflected the profit or loss accrued
during such a year.

NLO

As an example, our Dow Theory analysis indicated that the primary trend
was bullish on July 23, 2009. At the time, the Dow Jones Industrial Average was
at 9,069.29. When the primary trend changed to bearish on August 2, 2011, the
Dow was at 11,866.62, an increase of +30% above the July 23, 2009 bullish
primary trend. Since August 2, 2011, the Dow has fallen as much as -12% (in two
months after that call) and gained +15% as of 2/24/2013 (annualized return of
+10.33%).

Answer:

I
agree. Most followers of the Dow Theory agree as to the existence of a primary
bull market during that time whose end was signaled on 08/02/2011. True to its
protecting function the Dow Theory spared investors for incurring further
losses as you rightfully note.

NLO

However, in the time
that you've published on Seeking Alpha you've indicated primary trends, two
full bull and bear primary trends for stocks and one full primary trend for gold,
which have all resulted in negative final numbers.

Answer:

With all due
respect, wrong as to the number of trends I signaled and equally wrong as to
the statement that all trends signaled ended up in losses. Facts are:

As far as stocks are
concerned, I signaled in my blog the existence of only one primary bull market. The primary bull market started
on June 4, 2012 and was signaled on June 29, 2012. The primary bull market
topped on October 4, 2012 and the exit was signaled on November 16, 2012.

The position taken
according to such a trend ended in modest profits as any reader can see here:

By the way, from
June 29 (buy date) and November 16 (sell date), four and a half months elapsed.

On January 2, 2013,
I signaled the existence of a new primary bull market. Until now, such bull
market remains in force with unrealized gains, and hence it is premature to
label my market call as a winner or a loser.

Bottom line: As far
as stocks are concerned, I have called and completed only one bull market, not
two, and the one I called ended up with modest profits not losses.

As to the bear
market, we should bear in mind that never ever I advised to short the
market. The sell signal merely implied to sell out of stocks, not to sell short
stocks. Thus, no “losses” can be ascribed to my calling a bear market. The bear
market was merely the sell signal that put an end to the only bull market Ihad previously called. Furthermore, the average duration of bull markets
(ca. 2 years) is not applicable to bear markets, which are short-lived in
general. I made this clear here.

NLO:

Additionally, you
readily admit, "I am very aware that recently this Dow Theory ‘flavor’ has
signaled too many signals in too short time." Isn't it worth reconsidering
the primary trend analysis that results in signals of less than 6 months?

Answer:

It is neither an aberration of the market, nor an
error of this market practitioner to spot primary trends that last less than 6
months.

Thus, there were 6 instances (out of 38 trades since
1897) according to the “classical/Rhea” Dow Theory that resulted in signals of
less than 6 months. Here you have the list:

DateDow IndPctg lostTime (days)

SELL

25/02/1969

899.8

-4.51226759

147

SELL

26/01/1970

768.88

-10.6244479

91

SELL

19/10/1978

846.41

-2.31965009

135

SELL

03/08/1990

2809.65

-4.27706554

60

SELL

29/09/2008

10365.45

-19.3310017

164

SELL

04/06/2012

12101.46

-1.56612982

164

Therefore, 15.7% of the trades were short-lived.
Please mind that only one such shorter-than-average bull market occurred within
a secular bull market. All of them occurred under secular bear markets.

Furthermore, it should be stressed that these 6
shorter bull markets were detected according to the “classical/Rhea” Dow
Theory. Thus, I see no mistake or need to reconsider the way I applied the Dow
Theory. Of course, I was aware that the bull market was short-lived, but this
is well within the limits of the past observations of the Dow Theory.

Having said this, it is true that the “Schannep’s
flavor” of the Dow Theory results in trades lasting on average less than those
made following the Dow Theory (as per Schannep’s book, page 101). Consequently,
the positions taken within trends determined by Schannep’s flavor last on average
13 months. However, this is a long shot from being a short term trader.
Furthermore, there are thoughtful studies (i.e. M.J. Mauboussin, “More than you Know. Finding Financial Wisdom
in Unconventional Places”,Columbia University Press, 2006, p. 126)that suggest that the accelerating rate of
industry changes means that the investment horizon for the investor (i.e.
portfolio turnover) must be shortened accordingly. If we bear in mind that
Schannep’s is the best performer Dow Theorist, we should conclude that there is
nothing wrong with slightly reducing the average duration of each position. Schannep
in his book is also convinced that modern accelerated times require a somewhat
more reactive approach.

NLO

While we disagree about the length of what a primary trend is, if it
results in gains of +0.30%, then those who are uninitiated by the breadth of
Dow Theory and its benefits may end up thinking (justifiably) that from a
cost/benefit standpoint, it may be more work than it is worth to follow Dow
Theory for that kind of return. After all, a 1-year CD could have garnered the
same annualized return without all the work.

Answer:

Trends are what they are, and we humbly have to take
what the market gives us. If a trend is weak, there is no way in the world to
extract big profits out of it. We go with the flow, but we cannot force the
flow to suit our wishes. As far as I know, neither the NLO, nor other Dow
Theorists have been able to extract significant profits from the stock market or
to beat buy and hold in the last six months (time I have been blogging and
making my analysis of the markets). Classical Dow Theorists were on the
sidelines during this period (which is nothing wrong, as I have nothing against
the classical/Rhea Dow Theory) and only on January 18, 2013, a primary trend
was signaled according to the “classical/Rhea” Dow Theory, which was echoed here.

Thus, there have been 3 instances where the
“classical/Rhea” Dow Theory returned modest profits below 5%. Here you have the
list:

DateDow
IndPctg Profit

SELL

01/06/1903

59.59

0.25235532

SELL

14/01/1913

84.96

3.72359907

SELL

23/03/1973

922.71

0.15521883

If we bear in mind that, in addition to these 3 “sub
par” trends, there were 9 instances where the investor lost money, it stands to
reason that many trends, even when detected according to the most orthodox Dow
Theory, fail to extract a meaningful profit from the trend.

With all due respect to the NLO, there is no failing
in the way I am applying the Dow Theory, unless one subtly wants to
excommunicate Schannep’s version, which is akin to excommunicating the best
performer of the pack.

As to the uninitiated that may be demoralized by the
lack of performance shown by the Dow Theory in the last few months, I have a
few words to say.

If any Dow Theory
amateur is deterred from adopting the Dow Theory because one transaction was
not able to beat 1-year CD, this amateur will remain an amateur for ever
because he lacks the wits to understand (and the stomach to digest) the nature
of long periods of underperformance, which isthe price to pay for long term outperformance (both in absolute returns
and risk-adjusted). If any single trade resulted in guaranteed money, then
technical analysis and the Dow Theory would self destruct. Everybody would be
following it. Precisely, what separates the winners from the quitters is the
ability to understand the nature of underperformance, as merely the price to pay to reduce significantly risk
and even outperform in the long run.

About Me

Disclaimer/Disclosure

This blog (dowtheoryinvestment.com) is strictly a personal journal applying my interpretation of Dow Theory principles to the action of the stock market and my musings about investment and trading in general. This blog is intended solely for entertaining, illustrative or informational purposes. I am not a registered investment advisor and neither the information nor the opinions expressed should be construed as a solicitation to buy or sell any stock, option, ETF, mutual fund, currency, commodity, or any other security. I am unaware of any readers personal circumstance, financial condition, risk tolerance or goals and objectives, so nothing read here should be considered advice suitable for them. Anyone reading this blog does so with the understanding that this is strictly meant as an analytical exercise and does not proffer actionable advice in any way, shape or form. Trading and investing always entail risk and possible loss of funds and should only be undertaken after appropriate due diligence by the trader/investor and after consulting a registered investment adviser.